Greenspan 'shocked' that free markets are flawed

WASHINGTON — Facing a firing line of questions from Washington lawmakers, Alan Greenspan - the former Federal Reserve chairman once considered the infallible "maestro" of the U.S. economy - admitted Thursday that he was wrong to trust free markets to regulate the financial system without stronger government oversight.

A fervent proponent of deregulation during his 18-year tenure at the Fed's helm, Greenspan has faced mounting criticism this year for having adamantly resisted efforts to rein in credit derivatives, an unchecked market whose excesses partially led to the current financial crisis.

"I have found a flaw" in free market theory, Greenspan said under intense questioning by Representative Henry Waxman, the Democratic chairman of the Government Oversight Committee of the House of Representatives. "I don't know how significant or permanent it is," Greenspan added. "But I have been very distressed by that fact."

In his testimony, Greenspan rejected the notion that he was personally responsible for what he called a "once-in-a-century credit tsunami."

He also defended the use of derivatives in general, but he admitted to Waxman that he had been "partially" wrong in not having tried to regulate the market for credit default swaps.

Pressed by Waxman, Greenspan conceded a more serious flaw in his own philosophy that unfettered free markets sit at the root of a superior economy.

"I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms," Greenspan said.

Waxman pushed the former Fed chief, who left office in 2006, to clarify his explanation.

"In other words, you found that your view of the world, your ideology, was not right, it was not working," Waxman said.

"Absolutely, precisely," Greenspan replied. "You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well."

Waxman challenged Greenspan's approach to regulating the mortgage industry while he was Fed chairman, saying that the Fed "had the authority to stop the irresponsible lending practices that fueled the subprime mortgage market." But Greenspan, Waxman said, "rejected pleas that he intervene."

The committee is holding hearings to determine what gaps in the regulatory structure abetted the crisis that has roiled the world's financial markets.

Greenspan appeared alongside Christopher Cox, the chairman of the U.S. Securities and Exchange Commission, and John Snow, who served as secretary of the Treasury early in the administration of President George W. Bush.

In his prepared remarks, Greenspan said he was in "a state of shocked disbelief" about the breakdown in the ability of banks to regulate themselves.

He also warned about the economic consequences of the crisis, saying that he "cannot see how we will avoid a significant rise in layoffs and unemployment." Consumer spending would decline, too, he said, adding that a stabilization of home prices would be necessary to bring the crisis to its end.

Saying that his thinking "has evolved" in the past year, Greenspan also defended his record.

"In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences," he said. "This crisis, however, has turned out to be much broader than anything I could have imagined."

Sheila Bair, the chairwoman of the Federal Deposit Insurance Corp., said Thursday that her agency and the Treasury were developing a proposal to use government loan guarantees and financial incentives to encourage mortgage lenders to modify home loans now in danger of foreclosure.

"Specifically," Bair said in testimony prepared for the Senate Banking Committee, "the government could establish standards for loan modifications and provide guarantees for loans meeting those standards. By doing so, unaffordable loans could be converted into loans that are sustainable over the long term."

She said that the FDIC was working "closely and creatively" with the Treasury to carry out the proposal.

Senators John McCain and Barack Obama, the major-party presidential candidates, are both pushing for stepped-up efforts to prevent more widespread foreclosures, which could have a cascading effect on the U.S. economy.

The Treasury Department already plans to use part of a $700 billion financial rescue fund to buy and renegotiate mortgages directly.

Senator Christopher Dodd, Democrat of Connecticut and chairman of the committee, had words of cautious praise for the Bush administration's emergency steps so far. "Few have any doubt that those actions have forestalled the worst-case scenario: complete seizure of the financial markets," he said.

But Dodd said that it was time now to focus on the underlying crisis. "It's time to stop the hemorrhaging of our housing markets that has bled out into the wider economy," he said.

The committee was also set to hear from Neel Kashkari, the assistant secretary of the Treasury who heads the Office of Financial Stability, which was set up to purchase troubled financial assets from financial firms under the $700 billion rescue plan.